Patching The Hole In Your Investment Bucket

Sue Thompson: According to some recent analysis by our marketing team, our clients are less likely than average to open emails that have the word “tax” in the subject line.  I thought about that fact when writing the title of this post – if people knew that the topic was tax efficient investing, would they be less likely to continue reading?

It’s understandable to have a strong aversion to the T-word, especially if you’re still reeling from the bill you had to pay last April 15th.  But that’s exactly why it’s better to address tax efficiency head-on and year-round, rather than waiting for a certain time of year when, frankly, it may be too late to do anything about it.  If you’re not consistently investing with an eye toward tax efficiency, chances are there’s a “hole” in your investment bucket.

Simply stated, taxes can have quite a negative impact on your portfolio’s return.  Just look at the illustration below, which shows the hypothetical growth of a $100,000 portfolio returning 4% per year.  Even a relatively conservative 1% tax cost can cause leakage in returns, preventing you from keeping more of what you earn.

So how do you go about patching that hole in your bucket?  First and foremost, it’s important to understand that not all investments are created equal from a tax-efficiency standpoint.  This is where many ETFs can have an advantage, because if they’re benchmarked to an index, the portfolio turnover tends to be relatively low.  The less selling that goes on in the fund, the fewer the opportunities for capital gains to be realized.

Also, a stand-alone ETF structure is generally considered to be relatively tax-efficient.  An ETF is bought and sold on an exchange, which means that if a large number of investors wish to sell their shares, they simply sell to willing buyers.  If there’s significant selling pressure in a traditional mutual fund, it can force the manager to sell securities in order to come up with cash for the redemptions.  For a comprehensive list of differences between ETFs and traditional mutual funds, click here.

In addition to being proactive about the tax efficiency of your investments, there are also tax strategies you can employ year-round that may reduce your overall liability come April 15th.  A common one is tax loss harvesting – identifying positions to sell at a loss in order to offset gains in the same portfolio.  This offset can only be done if the investor refrains from purchasing the same security within 30 days of the sale, but if you want to maintain exposure to the same asset class during that 30-day period, you may be able to do so with a highly correlated ETF[i].  The iShares Correlation Calculator is a great tool for employing this strategy.

Over the next few months, I’ll be sharing more about tax efficient investing and strategies to help guide you through the end of the year.  Let me know in the comments section if there are any tax-related topics you’d like me to address!

Written By Sue Thompson From The iShares Blog

Sue Thompson, CIMA® is Head of the Registered Investment Advisor Group and 401(k) Sales, overseeing the firm’s iShares efforts with registered investment advisors, independent broker/dealers and asset managers.

Prior to joining Barclays Global Investors (BGI, which merged with BlackRock in 2009) in 2007, Sue was a principal at Vanguard, heading the national sales team focused on national full service brokerage firms. She joined Vanguard in August 1999 as Senior Counsel, specializing in tax law and structured products. Prior to joining Vanguard, Sue was an attorney at Orrick, Herrington & Sutcliffe, LLP in California, specializing in public finance. She received her B.A. in Accounting from the University of Washington and J.D. from the University of California, Davis. In addition to holding her Series 7, 63 and 24 FINRA licenses, Sue is also a C.P.A. and holds her Certified Investment Management Analyst (CIMA) designation through the Investment Management Consultants Association in conjunction with the Wharton School at the University of Pennsylvania.

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